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Although analysts following the property/casualty insurance industry expect underwriting results for 2012 to be better than 2011 when full-year numbers are tallied, double-digit overall returns-on-equity are still not visible on the near-term horizon, they say.
Industry analysts who supplied combined ratio estimates to Insurance Journal for 2012 have pegged them in the 104 to 108 range. Even though the numbers reflect a two-to-four point impact from $15-$25 billion of insured losses from Superstorm Sandy, they represent an improvement from the 108.2 figure recorded for 2011 for U.S. P/C insurers when catastrophe losses for the group were bigger ($38 billion of U.S. insurers).
In 2013, the underwriting result could improve to a breakeven combined ratio, said James Auden, managing director for Fitch Ratings in Chicago, who provided the most optimistic combined ratio forecast for next year. But even Auden, who factored “continued pricing momentum” into his favorable assessment, said the price hikes that started in mid-year 2011 are not enough to drive ROEs into double-digit territory. In addition, he questioned whether pricing discipline would even last past mid-year 2013.
“We were a bit surprised that the momentum this year has been sustained this long,” he said. Sandy, especially in commercial property and other catastrophe-affected segments, should help sustain pricing in the first-half of 2013, he said.
Jasper Cooper, associate analyst, Moody’s U.S. Insurance team, echoed the view. “We expect insurers to use Sandy to support continued rate increases for 2013 for the property lines,” he said.
Turning to commercial liability lines, Cooper noted that 2012 was the first year where price increases were “high enough to more than offset loss cost trend. As a result, we expect the combined ratio for accident-year 2012 to fall for the first time in six years,” he said.
Moody’s predicts accident-year commercial liability combined ratios (including workers’ compensation) of 107.5 for 2012 and 104 for 2013, down from 110 in 2011, assuming continued price increases in 2013.
Low Investment Returns Fuel Pricing
As for ROEs, through six months, the average for the P/C industry was 6.9 percent, according to figures published by ISO and the Property Casualty Insurers Association of America in October, rebounding from a 3.5 percent ROE for 2011. Separately, David Paul, a research analyst and principal for ALIRT in Windsor, Conn., calculated a 6.4 percent pretax ROE for a group of largest 50 P/C insurers through nine months, and an 8.2 percent average pretax return on earned premiums. Both metrics, while better than 2011 levels, fall below 17-year pretax averages and “are slowly migrating to profitability levels last reported in the period 1998-1999, toward the end of the last soft market cycle,” he said.
Gregory Locraft, an executive director for Morgan Stanley Research, explains that low investment yields are the anchor weighing ROEs down below 10 percent. “Net investment income accounts for more than 80 percent of P/C profitability,” Locraft wrote in a third quarter research note, adding that “the secular decline in interest rates has long been a headwind.”
“We see it continuing in 2014,” he said.
Locraft added, however, that low investment income might be “a harbinger of higher pricing.”
ALIRT’s Paul, who said that the average net investment yield fell to 3.4 percent in the first nine months of 2012, compared to nearly 4.0 percent for the full year 2012 for his 50-company composite, agreed. “It is likely that lower net investment yield is one of the primary drivers of firming rates, especially in the longer-tail commercial lines,” he said.
As investment returns decline, “carriers will be forced to raise prices simply to hold ROEs constant,” Locraft said, characterizing this as a possible “silver lining in what is a gloomy outlook for P/C investment income.”
Meyer Shields, a managing director of Equity Research for Stifel Nicolaus, gave a half-hearted nod to that line of reasoning. “I do think it will force [insurance] rate up because that’s the only lever companies can control — and they need to,” Shields said.
“On the other hand, we’re talking about really bad results. The only way we’re going to get from here to there is by going through these terrible results.”
“So if we’re going to have bad results anyway, then we’re better off with rising rate levels. But it’s a lot of cloud and very little silver lining,” he said.
Shields expects a 2012 combined ratio of roughly 107, including about 3.5 points for Sandy. “We’re expecting fairly weak underwriting results. Depending on the company, some will be disguised by reserve releases; some will not be.”
“The bigger issue is that investment income has historically been much more stable than underwriting income. As interest rates continue to decline, and there is a greater reliance on underwriting income to fill that gap, then insurance companies are replacing more predictable or higher-quality earnings [that used to come from investments] with less predictable, more volatile [underwriting] earnings,” he said.
Jerry Theodorou, a vice president for Conning, noted that net investment income was down 4.7 percent through the third quarter, adding that Conning expects a slightly larger decline for the full year. “We also project modest declines in net investment income in 2013 and 2014,” he said, noting that with the low interest rate environment expected to continue, maturing bonds are rolling over to significantly lower-yielding instruments.
ROEs Stuck In Single Digits
Shields said that targeted overall returns-on-equity would have been between 12 and 15 percent in a higher interest rate environment. Now, actual returns are “hovering somewhere in the mid-to-upper single digits, depending on the company,” he said, noting that he expects an overall industry return in that range for 2012 and 2013.
“What we are not seeing is companies taking more asset risk to boost yield or widening duration or taking more credit risk,” Fitch’s Auden said. “Overall, that’s a good thing. But when the investment contribution to earnings is a lot lower, there’s only one place to make it up — the underwriting side,” he said.
Like Shields, however, Auden doesn’t believe the magnitude of underwriting and pricing improvements needed to get ROEs past 10 percent are achievable in 2013.
“To get to a 10 percent return on surplus given current yields, the industry would have to be at a 95 combined ratio,” Auden says, noting that Fitch expects a 103 or 104 calendar-year combined ratio for 2012. On an accident-year basis, which excludes the impact of changes in prior-year loss reserves, the figure moves to 105 — 10 points above the needed 95, he said.
“We could see returns-on-surplus in an average catastrophe year getting to 7 percent next year. Maybe it gets back up to 8 or so” at best, he said.
Like Auden, Shields distinguishes between accident-year results and calendar-year results as he details some of the factors underlying his forecasts: a calendar-year combined ratio of 107 for 2012, a 104-105 range for 2013 and single-digit ROEs in both years.
Referencing a recent analysis by his firm, he notes that prior-period reserve releases, which have been improving reported calendar-year results in recent years, “are slowing down pretty dramatically” for the overwhelming majority of commercial lines of business.
“As that leg of the earnings stool falls away, we’re just left with particularly discouraging accident-year results,” he said, adding that slightly higher medical cost inflation will also hurt underwriting profits. “I’m not talking about skyrocketing numbers. It’s certainly within control, just worse than it had been,” he said, noting that the external catalyst of inflation, “in addition to normal cyclical factors translating into smaller reserve releases,” will push reserve development “to a worse, more adverse scenario.”
In general, he predicts reserve additions, not takedowns in 2013, but still offers a combined ratio forecast that’s two-to-three points lower than for 2012. “Rate increases that started last year and are now compounding themselves should start to improve accident-year numbers,” he said, noting that the expected improvement from pricing should outweigh deterioration in the reserve-development numbers.
Still, “I don’t think we’re at or close to double-digit [ROEs] for 2013,” he said.
Are such returns gone for the foreseeable future?
“I’m inclined to say that, yes — because such dramatic increases would be needed to compensate for the loss of investment income,” Shields said. “This is still a very overpopulated industry, which would make it very difficult for that level of price discipline to show up.”
William Wilt, president of Assured Research, offers some back-of-the envelope calculations indicating that insurance prices would need to increase north of 20 percent in one year to get the industry back to a low-to-mid-teens average ROE in 2013, assuming that loss cost trends remain as benign as they have been in recent years. Alternatively, two years of price hikes above 10 percent or three years near 7 percent could similarly lift returns to the low-to-mid teens. “That’s not entirely unrealistic,” he suggests.
But is a low-teens ROE the right target, given the low level of interest rates for the near-to-medium term future, Wilt asked in a November research note, which compared P/C insurers to other risk-bearing financial institutions that are similarly “mired in the middish-single digit range.”
Wilt suggests that P/C insurer ROEs are comparable if not better than other financial firms, as price hikes lift the P/C insurer ROEs trend into the upper-single-digit range and beyond. In contrast, analysts surveyed for a report commissioned by Accenture earlier this year have greater expectations of P/C insurers.
The survey of 68 insurance equity analysts from North America, Asia Pacific, Europe, Africa and Latin America performed in March and April, reveals that they expected “superior” global insurers — those they recommend with “Buy” ratings — to deliver an average pre-tax ROE of 14.2 percent in 2012. And half of the analysts expect higher returns from these insurers in the next three years.
Carving out just North American analysts from the group, the expectation drops to 13.7 percent.
Auden noted that while double-digit ROEs are not achievable across the industry, “pricing has gotten to a point where if you look at some of the better underwriters individually, they were producing 10-12 percent returns.”
John Del Santo, global managing director of Accenture’s Insurance practice, said that 38 of the 68 analysts surveyed focus exclusively on P/C, adding that the P/C group’s double-digit ROE expectations have been consistent in three studies published since 2008. “If they’re going to recommend an insurance company as an investment, they’re going to expect a fairly strong ROE and at least some growth,” he said.
According to the survey, the analysts expect average annual growth of 6.4 percent (organic or through acquisitions) from the P/C insurance companies they recommend to investors.
What Do Financial Analysts Expect?
Combined Ratios By Line
Moody’s Investors Service, in a report published in September 2012, provided combined ratio forecasts for commercial lines. Analysts told IJ in December that they have not significantly changed their views, summarized below.